What is the Equity asset class? Why invest in common shares? How does your life cycle phase, personal circumstances, and risk tolerance impact your target asset allocation to equity investments?
All that and more in Episode 27 on the Wilson Wealth Management YouTube channel.
“What is Equity as an asset class? What are some of the key subclasses?”
We start off with a quick review of the asset class as whole.
For more detail on equities, please review “Equity Asset Class” and “Common Share Characteristics”.
Then we drill down into the diversification and risk-return characteristics of various equity subclasses.
For example, investing by style. Value versus growth investing. Maybe your focus is on generating dividend income rather than capital gains. Perhaps you want to invest based on market capitalization. Mega companies like Apple, Nestle, and Toyota. Or down to small, micro, or nano capitalized companies.
I discuss differences between domestic and international equities. How the risk-return profile and asset correlations differ between developed, emerging, and frontier capital markets. There may also be differences between developed markets, such as EAFE (Europe, Australasia, Far-East) and the US. As well as between individual emerging markets. India and China are much different than Colombia or Qatar.
Not all equities are equal. Two investors may have the same percent allocated to equities. But the characteristics of that allocation may be vastly different.
Note the difference between “global” and “international”. Domestic equities are from your home market. International equities are from around the world, excluding your domestic market. Global include both domestic and international securities. Useful to remember when assessing investment products.
Next we move back into how your life cycle phase affects your equity asset allocation.
“How should Accumulators utilize equities in portfolios?”
Because Accumulators tend to be young, they have a very long time horizon for investing. At least, for the major goal of retirement. The time horizon means Accumulators can handle enhanced portfolio volatility and expect higher returns over time. This suggests heavy exposure to equities.
For many Accumulators, “heavy exposure” means a 100% equity allocation in their early years. However, as discussed with cash and fixed income, there are other factors that recommend some allocation to the other classes. Diversification benefits and short term objectives are two good reasons.
“What about those in the Consolidation phase?”
Consolidators still have a relatively long time frame until retirement. That suggests equities.
However, Consolidators may have more near term objectives and may now decide to focus on diversification as they have more wealth accumulated.
Because Consolidators do have some capital built up, they have the critical mass to better diversify into niche equities than do Accumulators. An Accumulator be may smart to invest in a cost-effective global equity fund as they build an investment foundation. A Consolidator may look for specific investments to improve diversification or try and take advantage of current trends.
Consolidators may have similar equity allocations as Accumulators, but the breakdown within the equities may differ.
“And for those in their Spending phase?”
As you might guess, being at, or near, retirement age means some shift to safer, more liquid assets. Such as fixed income. So the equity allocation is usually lowered when people become Spenders.
But there can still be a long time period to live. With people often living into their 90s, investors might have 30 years to live off their wealth. With inflation and low returns on fixed income, that means Spenders may still need a decent equity allocation.
But the allocation with equities may change. Instead of higher risk frontier markets or micro-cap investments, there may be a shift into more Blue-Chip investments. Or value stocks that generate dividend income, but still have upside capital gain potential.
“How does an investor’s risk tolerance factor in to the target allocation?”
In two key ways, as we saw above in the examples.
One is in the overall equity target allocation. A person’s circumstances or risk tolerance will drive the overall equity allocation.
If you are young, with a long time horizon, accepted investment theory might suggest 80-90% in equities. Whereas, for retirees, maybe a general level should be 50-60%, then adjusted down as years pass.
Also, what is the overall level of wealth. If you have $10 million in assets and only need $50,000 a year to live on, then you can take a low risk allocation with little allocated in equities. If you have $500,000 saved and require $50,000 annually, then you will need to take on more risk.
That is more the unemotional, rational approach to risk and an equity allocation.
However, your emotional view of risk may adjust the equity allocation further.
For some retirees, 50% in common shares may be too high for their comfort. And ability to sleep at night. They may prefer the safety and stability of cash or fixed income over the higher volatility of shares. Likely, these same investors had relatively low equity allocations even in their younger years. Some people are simply more risk averse than others.
Two is the equity investments within the equity allocation itself.
Do you prefer relatively lower risk equities? Blue-Chip companies. Value stocks. Dividend producers.
Do you gravitate towards higher risk investments? Micro-cap stocks. Growth. Frontier markets.
What about the investment itself? A well-diversified global equity fund. Versus individual companies. Maybe with a focus on small-cap mining companies operating in Africa.
The risk-return profile can vary wildly within an asset class. Your personal risk tolerance will dictate the way you invest within that class. And that can create much different risk levels for the overall portfolio.
A relatively short, but good overview of equity considerations in your target asset allocation. Very useful to compare the life cycle phases between cash, fixed income, and equities. Also, how both your personal financial situation and risk appetite will impact your equity allocation. As a percentage of the entire asset allocation. As well as the riskiness inherent in the equities themselves.
